Introduction

MutualFirst Financial, Inc., a Maryland corporation, is a savings and loan holding company and its wholly-owned subsidiary is MutualBank, Muncie, Indiana. MFS Financial, Inc. was formed in September 1999 to become the holding company of MutualBank in connection with MutualBank's conversion from the mutual to stock form of organization on December 29, 1999. In April 2000, MFS Financial, Inc. formally changed its corporate name to MutualFirst Financial, Inc. ("MutualFirst"). The words "we," "our" and "us" refer to MutualFirst and MutualBank on a consolidated basis, except that references to us prior to December 29, 1999 refer only to MutualBank.

Our principal business consists of attracting retail deposits from the general public and investing those funds primarily in permanent loans secured by first mortgages on owner-occupied, one-to four-family residences, a variety of consumer loans, loans secured by commercial and multi-family real estate and commercial business loans. We are headquartered in Muncie, Indiana with 33 retail offices primarily serving Delaware, Elkhart, Grant, Kosciusko, Randolph, St. Joseph and Wabash counties. MutualBank also has trust offices in Carmel and Crawfordsville, Indiana and a loan origination office in New Buffalo, Michigan. We also originate mortgage loans in counties contiguous to these counties, and we originate indirect consumer loans throughout Indiana.

In August 2006, MutualBank purchased three branch offices in Winchester, Wabash and Warsaw, Indiana, resulting in the acquisition of $8.7 million in assets and the assumption of $12.4 million in liabilities for $1.0 million in cash. The assets purchased included residential real estate mortgage loans of $5.4 million, and consumer loans of $1.2 million. The liabilities assumed included total deposits of $12.3 million.

On March 22, 2007 the Bank completed the acquisition of Wagley Investment Advisors, Inc. Wagley Investment Advisors, Inc. is now known as Mutual Financial Advisors, providing new and expanded investment management services not previously offered by the Bank. Mutual Financial Advisors offers a full range of non-bank investment options and money management.

On July 18, 2008, the Company acquired MFB Corp. ("MFB") and merged MFB's subsidiary bank, MFB Financial into MutualBank. MutualFirst issued an aggregate of 2.9 million shares of its common stock and paid approximately $11.5 million in cash to MFB stockholders in the transaction. MutualFirst also assumed 114,500 MFB stock options, which have converted into approximately 296,555 MutualFirst stock options with a weighted average exercise price of $9.90 per share. As a result of the transaction, MutualBank now has 33 retail financial centers, spanning nine Indiana counties and is the 11th largest depository institution headquartered in Indiana. MutualBank also has a trust office in Carmel and Crawfordsville, Indiana and a loan origination office in New Buffalo, Michigan.

On December 23, 2008, as part of the Troubled Asset Relief Program ("TARP") Capital Purchase Program, the Company entered into a Letter Agreement and Securities Purchase Agreement (collectively, the "Purchase Agreement") with the United States Department of the Treasury ("Treasury"), pursuant to which the Company (i) sold 32,382 shares of the Company's Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the "Series A Preferred Stock") for a purchase price of $32,382,000 in cash and (ii) issued a warrant (the "Warrant") to purchase 625,135 shares of the Company's common stock, par value $0.01 per share (the "Common Stock"), for a per share price of $7.77 per share. The Series A Preferred Stock is entitled to cumulative dividends at a rate of 5% per annum for the first five years, and 9% per annum thereafter. The Series A Preferred Stock may be redeemed by the Company at any time, subject to consultation by the Treasury with the Officer of Thrift Supervision ("OTS"). The Warrant has a 10-year term and is immediately exercisable upon its issuance, with an exercise price, subject to anti-dilution adjustments, equal to $7.77 per share of the Common Stock. If the Series A Preferred Stock is redeemed, the Warrant will be liquidated at the current market price. The Warrant is attached as Exhibit 4.2 hereto and is incorporated herein by reference. Treasury has agreed not to exercise voting power with respect to any shares of Common Stock issued upon exercise of the Warrant that it holds.

Pursuant to the terms of the Purchase Agreement, the ability of the Company to declare or pay dividends or distributions on, or purchase, redeem or otherwise acquire for consideration, shares of its Junior Stock (as defined below) and Parity Stock (as defined below) will be subject to restrictions, including a restriction against increasing dividends from the last quarterly cash dividend per share ($0.16) declared on the Common Stock prior to December 23, 2008. The redemption, purchase or other acquisition of trust preferred securities of the Company or its affiliates also will be restricted. These restrictions will terminate on the earlier of (a) the third anniversary of the date of issuance of the Series A Preferred Stock, (b) the date on which the Series A Preferred Stock has been redeemed in whole; and (c) the date Treasury has transferred all of the Series A Preferred Stock to third parties. In addition, the ability of the Company to declare or pay dividends or distributions on, or repurchase, redeem or otherwise acquire for consideration, shares of its Junior Stock and Parity Stock will be subject to restrictions in the event that the Company fails to declare and pay full dividends (or declare and set aside a sum sufficient for payment thereof) on its Series A Preferred Stock. "Junior Stock" means the Common Stock and any other class or series of stock of the Company the terms of which expressly provide that it ranks junior to the Series A Preferred Stock as to dividend rights and/or rights on liquidation, dissolution or winding up of the Company. "Parity Stock" means any class or series of stock of the Company the terms of which do not expressly provide that such class or series will rank senior or junior to the Series A Preferred Stock as to dividend rights and/or rights on liquidation, dissolution or winding up of the Company (in each case without regard to whether dividends accrue cumulatively or non-cumulatively).

The Company placed $29.1 million of TARP proceeds into its wholly-owned subsidiary MutualBank, while maintaining the $3.2 million with the Company. MutualBank placed approximately $20.0 million of the proceeds in highly rated securities. Approximately $14.8 million was placed in mortgage securities, $3.2 million in municipal securities and $2.0 million in corporate bonds. These securities will provide liquidity as needed to meet current and future loan demand. The remaining funds held at MutualBank were placed in working capital, which was used to fund loans and meet the cash needs of MutualBank.

The following discussion is intended to assist your understanding of our financial condition and results of operations. The information contained in this section should be read in conjunction with our consolidated financial statements and the accompanying notes to our consolidated financial statements.

Our results of operations depend primarily on the level of our net interest income, which is the difference between interest income on interest-earning assets, such as loans, mortgage-backed securities and investment securities, and interest expense on interest-bearing liabilities, primarily deposits and borrowings. The structure of our interest-earning assets versus the structure of interest-bearing liabilities along with the shape of the yield curve has a direct impact on our net interest income. Historically, our interest-earning assets have been longer term in nature (i.e., fixed-rate mortgage loans) and interest-bearing liabilities have been shorter term (i.e., certificates of deposit, regular savings accounts, etc.). This structure would impact net interest income favorably in a decreasing rate environment, assuming a normally shaped yield curve, as the rates on interest-bearing liabilities would decrease more rapidly than rates on the interest-earning assets. Conversely, in an increasing rate environment, assuming a normally shaped yield curve, net interest income would be impacted unfavorably as rates on interest-earning assets would increase at a slower rate than rates on interest-bearing liabilities.

The acquisition of MFB in July 2008 and the sale of $92.9 million of fixed rate mortgages in 2008 helped change the structure of MutualBank's balance sheet. Net interest income should be less vulnerable to changes in interest rates. The Federal Funds rate set by the Board of Governors of the Federal Reserve System has decreased to a range of 0 to 25 basis points as of December 31, 2008. The Federal Funds rate at this level decreases the ability to reprice deposits lower in future months. Certificates of deposit and borrowings may, however, still reprice to lower rates at their maturities in future time periods, which could reduce the amount of interest expense. Interest income is expected to decrease without any changes in the current rate environment primarily due to the rates on newly originated interest-earning assets are lower than the rates on maturing interest-earning assets. Another factor that may lead to changes in net interest income is the level of non-performing assets. An increase in non-performing assets (i.e., loans, repossessed assets, or securities) would also decrease interest income and may decrease overall net interest income without additional decreases in interest-bearing liabilities.

Results of operations are also dependent upon the level of the Company's non-interest income, including fee income and service charges, and the level of its non-interest expense, including general and administrative expenses. MutualWealth, the wealth management division of the Bank, produces non-interest income for the Bank that is tied primarily to the market value of the portfolios being managed. As of December 31, 2008, MutualWealth had $352.0 million of assets under management. Decreases in market value could have a negative impact on the non-interest income generated by this division of the Bank.

Difficult market conditions and economic trends have adversely affected our industry and our business.

Dramatic declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, have negatively impacted the credit performance of mortgage and construction loans and resulted in significant write-downs of assets by many financial institutions. General downward economic trends, reduced availability of commercial credit and increasing unemployment have negatively impacted the credit performance of commercial and consumer credit, resulting in additional write-downs. Concerns over the stability of the financial markets and the economy have resulted in decreased lending by financial institutions to their customers and to each other. This market turmoil and tightening of credit has led to increased commercial and consumer deficiencies, lack of customer confidence, increased market volatility and widespread reduction in general business activity. Financial institutions have experienced decreased access to deposits or borrowings.

The resulting economic pressure on the consumer and businesses and the lack of confidence in the financial markets may adversely affect our business, financial condition, results of operation and stock price.

Our ability to assess the creditworthiness of customers and to estimate the losses inherent in our credit exposure is made more complex by these difficult market and economic conditions. We also expect to face increased regulation and government oversight as a result of these downward trends. This increased government action may increase our costs and limit our ability to pursue certain business opportunities. We also may be required to pay even higher Federal Deposit Insurance Corporation premiums than the recently increased level, because financial institutions failures resulting from the depressed market conditions have depleted and may continue to deplete the deposit insurance fund and reduce its ratio of reserves to insured deposits.

We do not believe these difficult conditions are likely to improve in the near future. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market and economic conditions on us, our customers and the other financial institutions in our market. As a result, we may experience increases in foreclosures, delinquencies and customer bankruptcies, as well as more restricted access to funds.

Recent legislative and regulatory initiatives to address these difficult market and economic conditions may not stabilize the US banking system.

The Emergency Economic Stabilization Act of 2008 ("EESA") authorizes the United States Department of Treasury, hereafter the Treasury Department, to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies in a troubled asset relief program. The purpose of the troubled asset relief program is to restore confidence and stability to the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other. The Treasury Department has allocated $350 billion towards the troubled asset relief program to the capital purchase program. Under the capital purchase program, the Treasury Department will purchase debt or equity securities from participating institutions. The troubled asset relief program is also expected to include direct purchases or guarantees of troubled assets of financial institutions.

EESA also increased Federal Deposit Insurance Corporation deposit insurance on most accounts from $100,000 to $250,000. This increase is in place until the end of 2009 and is not covered by deposit insurance premiums paid by the banking industry. In addition, the Federal Deposit Insurance Corporation has implemented two temporary programs to provide deposit insurance for the full amount of most non-interest bearing transaction accounts through the end of 2009 and to guarantee certain unsecured debt of financial institutions and their holding companies through June 2012. Financial institutions have until November 12, 2008 to opt out of these two programs. The purpose of these legislative and regulatory actions is to stabilize the volatility in the U.S. banking system.

EESA, the troubled asset relief program and the Federal Deposit Insurance Corporation's recent regulatory initiatives may not stabilize the U.S. banking system or financial markets. If the volatility in the market and the economy continue or worsen, our business, financial condition, results of operations, access to funds and the price of our stock could be materially and adversely impacted.

The recently enacted American Recovery and Reinvestment Act of 2009 (the "AARA") is a broad based economic stimulus bill that contains a broad range of tax revisions and government spending to address the national economic decline. It does not contain any specific provisions governing financial institutions, except for TARP recipients. It imposes new compensation limits and requirements on TARP recipients and allows TARP funds to be returned with the requirements for replacement capital or the passage of set time periods included in the TARP agreement.

Management Strategy

Our strategy is to operate as an independent, retail-oriented financial institution dedicated to serving customers in our market areas. Our commitment is to provide a broad range of products and services to meet the needs of our customers. As part of this commitment, we are looking to increase our emphasis on commercial business products and services. We also operate a fully interactive transactional website. In addition, we are continually looking at cost-effective ways to expand our market area.

Financial highlights of our strategy have included:

· Continuing as a Diversified Lender. We have been successful in diversifying our loan portfolio to reduce our reliance on any one type of loan. From 1995 through 2000, approximately 36% of our loan portfolio consisted of loans other than one-to four- family real estate loans. Since that time to the end of 2008, that percentage has increased to 53%.

· Continuing as a Leading One- to Four-Family Lender. We are one of the largest originators of one- to four-family residential loans in our five-county market area. During 2008, we originated $111.1 million of one- to four-family residential loans.

· Continuing To Focus On Asset Quality. Non-performing assets to total assets was 1.92% at December 31, 2008, up from 1.35% at December 31, 2007. We believe that our underwriting standards will provide for a quality loan portfolio.

· Continuing Our Strong Capital Position. As a result of our consistent operating profitability, we have historically maintained a strong capital position. At December 31, 2008, our ratio of stockholders' equity to total assets was 9.4%.

Since 2000 it has been MutualFirst's strategic objective to change the repricing structure of its interest-earning assets from longer term to shorter term to better match the structure of our interest bearing liabilities and therefore reduce the impact interest rate changes have on our net interest income. Strategies employed to accomplish this objective have been to increase the originations of variable rate commercial loans and shorter term consumer loans and to sell longer term mortgage loans.

During 2008, in keeping with its strategic objective to reduce interest rate risk exposure, MutualFirst also sold $92.9 million of long term fixed-rate loans that had been held for sale, which reduced potential earning assets and therefore had a negative impact on net interest income. This was offset, in the short term, by recognizing a gain on the sale of these loans of $1.4 million during the year.

Financial Condition at December 31, 2008 Compared to December 31, 2007

General. Our assets increased $426.3 million during 2008, ending the year at $1.4 billion compared to $962.5 million at December 31, 2007. Liabilities increased $382.8 million or 43.7% during 2008 to $1.3 billion at December 31, 2008. Stockholders' equity increased $43.5 million to $130.5 million at December 31, 2008. These increases were primarily due to the acquisition of MFB and are discussed in further detail below.

Loans. Our net loan portfolio increased $310.7 million from $802.4 million at December 31, 2007, to $1.1 billion at December 31, 2008, primarily due to the acquisition of MFB. Consumer loans increased $42.9 million or 19.0% from $225.5 million at December 31, 2007 to $268.4 million at December 31, 2008. Most of the consumer loan growth came from home equity loans acquired from MFB, which increased $39.2 million or 144.1% from $27.2 million to $66.5 million. Recreational vehicles increased $2.1 million to $79.9 million and other consumer loans increased $3.0 million to $5.8 million at December 31, 2008. The remainder of the consumer portfolio decreased slightly. Commercial business loans increased $18.5 million or 32.6% from $56.8 million to $75.3 million at December 31, 2008. It has been our strategy to increase non-real estate mortgage loans as a percentage of our loan portfolio in order to mitigate interest rate risk and enhance the portfolio yield. Accordingly, we sold $92.9 million of our fixed rate one- to four-family mortgage loans in 2008. Despite this, real estate mortgage loans increased $256.5 million or 48.5% from $529.0 million to $785.4 million at December 31, 2008 primarily due to the acquisition of MFB. Mortgage loans held for sale decreased $104,000 to $1.5 million at December 31, 2008.

Allowance For Loan Loss. Allowance for loan losses increased $6.8 million, including $3.0 million acquired with MFB, to $15.1 million at December 31, 2008 when compared to December 31, 2007. Specific loan loss reserves have increased $658,000, while general loan loss reserves have increased $6.1 million since December 31, 2007. Net charge offs for the year 2008 were $3.2 million, or .34% of average loans on an annualized basis, compared to $2.0 million, or .25% of average loans for the comparable period in 2007. The increase was primarily due to increased charge offs on commercial real estate loans during 2008. As of December 31, 2008, the allowance for loan losses as a percentage of loans receivable and non-performing loans was 1.34% and 69.41%, respectively, compared to 1.03% and 79.72%, respectively, at December 31, 2007.

Securities. Investment securities available for sale increased $33.7 million, or 77.1%, compared to December 31, 2007 due primarily to $23.9 million acquired with MFB. Investment securities held to maturity increased $9.7 million due to securities received in the third quarter of 2008 through a redemption in kind as a result of a liquidation of a mutual fund.

Liabilities. Our total liabilities increased $382.8 million or 43.7% to $1.3 billion at December 31, 2008 from $875.5 million at December 31, 2007. Deposits increased $296.1 million, and borrowed funds increased $82.5 million as a result of the acquisition of MFB.

Stockholders' Equity. Stockholders' equity increased $43.5 million, or 50.0%, from $87.0 million at December 31, 2007, to $130.5 million at December 31, 2008. The increase was due primarily to stock issued to acquire MFB of $39.8 million, preferred stock issued to the United States Treasury Department of $32.4 million, and Employee Stock Ownership Plan (ESOP) and RRP shares earned of $364,000. This increase was partially offset by a net loss of $22.1 million, the repurchase of 154,000 shares of common stock for $1.8 million and dividend payments of $3.5 million. Also, the market value of securities available for sale compared to their book value decreased $1.5 million from a loss of $414,000 at December 31, 2007 to a loss of $1.9 million at December 31, 2008. An increase on a postretirement benefit obligation decreased equity $110,000. As of December 31, 2008, the Bank's capital ratio was 13.79%, well in excess of "well-capitalized" levels as defined by all regulatory standards. The Company's tangible equity to tangible asset ratio was 6.79%.

Financial Condition at December 31, 2007 Compared to December 31, 2006

General. Our assets increased $1.7 million during 2007, ending the year at $962.5 million compared to $960.8 million at December 31, 2006. Liabilities increased $1.9 million or 0.22% during 2007 to $875.5 million at December 31, 2007. Stockholders' equity decreased $250,000 to $87.0 million at December 31, 2007 as a result of stock repurchases and cash dividends of $5.2 million which were partially offset by net income, employee benefits earned and stock options exercised of $5.0 million.

Loans. Our net loan portfolio decreased $3.2 million from $805.6 million at December 31, 2006, to $802.4 million at December 31, 2007, primarily due to slower loan production in 2007. Consumer loans increased $2.5 million or 1.1% from $223.0 million at December 31, 2006 to $225.5 million at December 31, 2007. Most of the consumer loan growth came from recreational vehicle and boat loans, which increased $8.0 million or 6.8% from $117.6 million to $125.6 million and home equity and home improvements loans, which increased $3.8 million or 5.5% from $68.6 million to $72.4 million. These increases were partially offset by a decrease of $8.4 million or 26.9% in automobile loans. Commercial business loans decreased $10.7 million or 15.9% from $67.5 million to $56.8 million at December 31, 2007. It has been our strategy to increase non-real estate mortgage loans as a percentage of our loan portfolio in order to mitigate interest rate risk and enhance the portfolio yield. Accordingly, we sold $24.1 million of our fixed rate one- to four-family mortgage loans in 2007. Real estate mortgage loans increased $3.7 million or 0.7% from $525.2 million to $529.0 million at December 31, 2007 primarily due to increases in commercial real estate loans of $8.2 million or 11.1%. Mortgage loans held for sale increased $315,000 to $1.6 million at December 31, 2007.

Allowance For Loan Loss. The allowance for loan losses increased $197,000 to $8.4 million at December 31, 2007. This increase included additional reserves of $2.2 million for 2007. Net charge-offs for the year were $2.0 million or 0.25% of average loans compared to $2.0 million or 0.24% of average loans in 2006. The increase in the allowance for loan losses was due to continued poor economic conditions in some of our markets and changes in the mix of loans in the portfolio. As of December 31, 2007, our allowance for loan losses as a percentage of loans receivable and non-performing loans was 1.03% and 79.72%, respectively.

Securities. Investment securities totaled $43.6 million at December 31, 2007 compared to $41.1 million at December 31, 2006, a 6.1% increase.

Liabilities. Our total liabilities increased $1.9 million or 0.22% to $875.5 million at December 31, 2007 from $873.6 million at December 31, 2006. Deposits decreased $37.0 million, and borrowed funds increased $37.8 million as a result of better market prices on borrowings when compared to certificate of deposits toward the end of 2007.

Stockholders' Equity. Stockholders' equity decreased $254,000 from $87.3 million at December 31, 2006 to $87.0 million at December 31, 2007. This decrease in stockholders' equity was the result of the repurchase of 155,400 shares of our common stock for $2.8 million and cash dividend payments of $2.4 million, which were partially offset by $4.2 million in net income, earned Employee Stock Ownership Plan shares of $583,000, earned tax-affected restricted stock shares of $3,000 and exercised stock options of $209,000. Also, the market value of securities available for sale compared to their book value decreased $60,000 from a loss of $355,000 at December 31, 2006 to a loss of $414,000 at December 31, 2007.

Average Balances, Net Interest Income, Yields Earned and Rates Paid

The following table presents for the periods indicated the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. No tax equivalent adjustments were made. All average balances are daily average balances. Non-accruing loans have been included in the table as loans carrying a zero yield.

Average Balances, Net Interest Income, Yields Earned and Rates Paid

                                                                                    Year ended December 31,
                                              2008                                           2007                                            2006
                             Average         Interest       Average          Average         Interest       Average          Average         Interest       Average
. . .